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Emerging Europe and Asia Since the mid-1990s the trajectories of the Asian and European emerging economies

current accounts have been startlingly dissimilar. Whilst emerging Asia has, on net, run a large current account surplus, emerging Europe has run a large deficit. The implications of these imbalances are profound, with potential dangers both for the two regions and the wider global economy. The current account records a countrys payments to and from the rest of the world. This includes payments from exports and imports, investment income and transfers. The capital account refers broadly to the trade in financial assets, such as bonds and equities, and non-financial assets, such as intellectual property. A country that runs a current account deficit must run an equal and opposite capital account surplus (Although statistical discrepancies means this is never actually observed). This is achieved through a deccumulation of a countrys stock of foreign assets implying an inward flow of foreign capital. Conversely, a country with a current account surplus runs a capital account deficit. Theory predicts that emerging economies should run current account deficits and that capital should flow downhill from rich economies to emerging ones. Fast growth in emerging economies creates profitable investment opportunities which should make the country attractive to foreign capital. Domestic agents, in anticipation of higher future growth rates, bring forward consumption and investment. Whilst this traditional view seems able to explain the current account deficits in emerging Europe it cannot account for the surpluses in Asia. Other, more idiosyncratic, factors must, therefore, play a prominent role in determining current account balances. In addition to the standard theory, a key causal factor behind the deficits in emerging Europe seems to be the process to of EU integration. An important aspect of EU integration has been financial liberalisation. By improving access to foreign capital for domestic investment, financial liberalisation seems to have lowered current accounts in the region. Partial explanation for the current account surpluses in Emerging Asia, on the other hand, can be offered by structural factors, such as a lack of financial liberalisation and the relative youth of the populations. Perhaps the most interesting factor, however, is the low exchange rates associated with the surplus countries in emerging Asia. Low exchange rates keep exports cheap internationally whilst making imports relatively expensive in domestic terms and, consequently, often result in a current account surplus. Emerging Europe Since the mid-1990s emerging Europe has run a current account deficit. With an average deficit of 18% of GDP in 2007, the deficits in the Baltics are the highest (IMF 2008). In the fourth quarter of 2006 the Latvian current account deficit was at a phenomenal annualised rate of 27.2% of GDP, although it has fallen significantly since (Bank of Latvia). The next highest are the deficits in south-eastern Europe with an average deficit of around 11% of GDP in 2007 (IMF). In Central Europe the average deficit is around 5% of GDP in 2007 (IMF). These large deficits run by the emerging European countries pose significant regional risks. Sudden Stops central Europe (Czech Republic, Hungary, Poland, Slovak Republic, Slovenia), Emerging Europe:
southeastern Europe (Albania, Bulgaria, Croatia, Macedonia, FYR, Romania), Baltics (Estonia, Latvia, Lithuania). Emerging Asia: Korea, Hong Kong, Singapore, Taiwan, Indonesia, Malaysia, Philippines, Thailand, China, India, Pakistan, Sri Lanka, Vietnam.

Emerging economies have in the past have frequently experienced sudden stops to capital inflows. Capital inflows are equal to a countrys current account deficit plus its accumulation of foreign reserves. Thus, a sudden stop implies a deccumulation of foreign reserves or an abrupt reduction in the current account deficit. As Calvo (1999) outlines, whilst the former increase a countrys financial vulnerability the later has severe implications for output and employment. The capital account deficit equals aggregate demand less GNP. Thus, a sudden reduction in the deficit implies a sharp reduction in aggregate demand and, consequently, a period of falling output and rising unemployment. Furthermore, Calvo emphasises the Fisherian channel affecting the financial sector following a sudden stop. As aggregate demand falls, the demand for both tradable and non-tradable goods falls. As non-tradable goods are restricted to the home market, this implies a reduction in the price of non-tradable relative to tradable goods. With a fixed exchange rate (Emerging European economies, such as Lithuania, Bulgaria and Latvia peg their currency to the Euro) and a stable exogenous price for tradable goods, the adjustment takes place through a reduction in the nominal price of non-tradable goods. The result of this is that domestic producers of non-tradables face a real increase in the value of predetermined loan repayments and interest rates. This increases the proportion of non-performing loans, inflicting damage to the financial sector. Consequently, the supply of credit contracts and, with lending to domestics firms and households cut back, the severity of the economic shock intensifies. Emerging Europe is, at present, experiencing the consequences of a sudden stop. Foreign capital, so abundant in the past decade, had dried up. A case in point is Latvia, which, after suffering the bankruptcy of its main commercial lender, Parex, is predicted to experience an economic contraction of around 12% of GDP this year. Although the dire economic situation in Latvia is not reflective of the region as a whole, the outlook for emerging Europe is nevertheless poor. The main ex-communist countries are forecast to contract by 3% of GDP this year (Economist). Foreign Debts Another risk of the substantial deficits is the accumulation of large foreign debts. Firstly, excessive debt external accumulation can hamper future economic performance (Becker, Tomassovits 2006). High tax rates, necessary to service and repay public debt, blunt incentives and deter entrepreneurship. In the private sector, productive investment projects and consumption are forgone in order to service debt. At the end of 2008 Latvias gross foreign indebtedness was 137% of GDP whilst Hungarys was in excess of 100% of GDP. Such high levels may prove to be damaging in the future. Secondly, excessive foreign indebtedness can causes crises when countries are unable to refinance debt. In the past decade or so, companies and financial institution in emerging Europe have been able to lend or invest in long term projects whilst borrowing for a shorter duration, refinancing periodically. However, if external capital is not available to refinance, a country must run down its reserves. One gauge, therefore, of vulnerability is the refinancing requirement of debt maturing in the next 12 months as a percentage of GDP. This is estimated, astonishingly, to be over 250% for both Estonia and Latvia, indicating the precarious situation the two countries find themselves in.

Thirdly, excessive domestic borrowing in foreign currency can lead to difficulties in the event of a currency devaluation or depreciation. In emerging Europe, many households and firms have borrowed in foreign currencies, mainly the Swiss Franc and the Euro, in order to take advantage of lower interest rates. A fall in the value of the national currency would result in the growth of the value of foreign liabilities, with such crises often effectively bankrupting large parts of emerging economies. The damage can be all the more pronounced because of the problems it can cause the financial sector. The situation is particularly precarious in countries such as Hungary and Latvia, which have significant borrowings denominated in foreign currency. The later saw lending in foreign currency increase from 60% of all lending in 2004 to 90% in 2008. Emerging Asia Emerging Asia has, on the other hand, experienced a net current account surplus, averaging around 5% of GDP in 2007. The picture, however, is more heterogeneous than in emerging Europe, with countries such as India and Pakistan running deficits. On the other hand, countries such as China and Malaysia have, in recent years, run vast surpluses. The two countries are again expected to run surpluses this year, estimated to be around 5.2% and 11.3 of GDP respectively (Economist). There are clear benefits to this large current account surpluses have allowed countries to accumulate vast foreign reserves. Large reserves can, to some extent, an economy from an external shock. However, the pattern of running large surpluses is not without its problems. Domestic Consumption and Investment forgone The current account surpluses in emerging Asia indicate that the region is, in an international context, a net saver. At the cost of postponing the consumption of imports emerging Asia has been able to accumulate foreign assets. But might at least some of this capital accumulated had have been better used to finance the purchase of welfare enhancing foreign imports? Calculating the true opportunity cost of running a current account surplus is very difficult. The extent to which consumers in emerging Asia value the financial stability provided by large reserves relative to a more tangible enhanced material wealth is not easy to discern. Nevertheless, estimates of the opportunity cost of, for instance, accumulating foreign reserves in terms of consumption forgone have been attempted. This has been estimated by the IMF as the differential between the interest rate at which people are willing to borrow in order to consume and the return on holding reserves. Under certain assumptions about the degree of relative risk aversion and consumer discount rates, the opportunity cost of the reserves held in emerging economies from 1980-2000 was calculated to be above 8% per year of average import growth for the same period (Jeane 2007). Perhaps China, with its vast foreign reserves, estimated to have reached $1956 billion in December 2008, could have achieved a higher level of economic welfare had it saved a little less, in the past decade or so, and consumed a little more. Managing Foreign Assets The accumulation of foreign assets by emerging Asian countries running current account surpluses presents the problem of managing these assets. Initially, in the wake of the Asian financial crisis, countries choose to replenish their severely depleted reserves. The reserve assets held by emerging Asian countries are typically dollar

denominated, low risk and highly liquid, such as US treasury bonds. However, such assets are low yielding and, around the turn of the century, many countries believed they had accumulated sufficient reserves to effectively mitigate the effects of an external shock. Thus, the number of sovereign wealth funds state owned investment vehicles that invest globally in stocks, bonds, commodities and other assets has grown sharply over the past few years. Sovereign wealth funds, such as the China Investment Corporation and the Taiwanese National Stabilisation Fund, were created in order to enhance returns on the capital held by central banks. Resources were transferred to fund managers, mandated to pursue aggressive investment strategies. With higher returns, however, comes higher risk and the investments of the sovereign funds have not always been judicious. The current financial crisis has exposed sovereign wealth funds to substantial losses. In 2007 China Investment Corporation took a $3 billion stake in the Blackstone Group at $29 per share as well as a $5 billion stake in Morgan Stanley at $50 per share. The value of both these investments have fallen dramatically, with the price of a share now $8 and $25 respectively. It is estimated that in the last year Gulf foreign reserve funds and sovereign wealth funds lost $350 billion (Economist). Although the losses suffered in the recent market turmoil are by no mean specific to sovereign funds, they do indicate the difficulties of managing the large stocks of foreign assets associated with current account surpluses. Global Issues The implications of the imbalances in emerging Europe are not limited to the two regions. Both imbalances potential pose significant challenges to the wider global economy. Reserve Diversification The emerging Asian countries running current account surpluses have been able to able accumulate large foreign reserves. These have typically been in dollar denominated low risk assets such as US treasury bills but, increasingly, the trend is one of diversification away from such assets. The diversification of the reserves of emerging economies has led to concerns that this process could cause problems for developed western economies. Capital inflows to the Euro area and, in particular, America would be expected to fall. Large reductions in the quantity of US treasury bonds held by the central banks of emerging economies could result in a sizeable depreciation of the dollar and increases in the long term US interest rates. Reduced capital inflows into western debt markets will increase the cost of for funding firms in Europe and the US. Although increased diversification of reserve assets need not necessarily imply any disorderly adjustments, they nevertheless may have significant effects for the global economy and should be monitored carefully. Contagion The current economic situation in some emerging European countries is grim. Latvia, Hungary and Ukraine, for instance, have all been in receipt of IMF bailouts - $16.4 billion, $25 billion and $6.4 billion respectively and all expect their economies to contract significantly. However, not all countries in emerging Europe have suffered similar fates. The two largest economies in this group, Poland and the Czech Republic,

despite their economies slowing, remain in robust shape. However, there is a risk that the problems in struggling countries may spread. One of the main risks of contagion is through the banking system. Western banks operating in the region have so far been a source of stability the Swedish government has extended its deposit guarantee scheme to its banks in the Baltic region. Yet if only one Western Bank were to walk away from a local subsidiary - perhaps, for instance, following difficulties recapitalising and left depositors stranded, the consequences would be severe. Confidence in the entire system could drain away, precipitating, potentially, a regional run on the banks. The risk of contagion isnt simply a regional one some advanced European economies are heavily exposed to emerging Europe. The Austrian banking system has lent Eastern Europe a sum equivalent to 80% of Austrian GDP. It is, furthermore, possible that, as the economic difficulties intensify, emerging European countries might succumb to protectionism. For instance, law makers may legislate to allow the repayment of foreign borrowings in local currency, a de facto expropriation of foreign banks loan books. With Italian and Swedish banks also heavily exposed to the region, it is possible that an emerging European banking crisis could spread to become a pan-European crisis. Through depressing European growth, this could in turn have global ramifications. Conclusion The pattern of current account imbalances in both emerging Europe and Asia do, then, pose problems to both the emerging regions and the wider global economy. The risks from the Asian imbalances are, however, seemingly the least concerning. For instance, the losses suffered by emerging Asian sovereign investment funds in Western financial firms, although undoubtedly irritating, do not pose any real risk to the regions economies. Similarly, the threats posed from the imbalances to the global economy seem limited. The threat of contagion from struggling emerging European economies, for example, though possible, is low. Latvia, the emerging European country presently experiencing the greatest economic difficulties, is tiny. Its population is a mere 2.5 million (equal to that of Manchester) and, with assistance from the international community, its problems are resolvable contagion need not become a problem. On the other hand, the threats posed to emerging European region from its large current account deficits, many of which are now being realised, are substantial. A flight of foreign capital has contributed to a severe economic contraction in much of the region. For the less prudently run emerging European economies, with their excessive levels of debt, the current economic crisis has proved devastating.

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